Tuesday, September 16, 2008

Could we have made them smarter? 

One of the purposes of this blog -- not originally, but one that evolved after NARN started -- was to provide more economic literacy to the general public. At times like this week it seems never more needed. But the traditional ways we provide this education are to me ineffective.

Some months ago San Francisco Fed president Janet Yellen spoke at the annual Community Reinvestment conference. I am not going to get into, in the following, the responsibility of federal regulation through the Community Reinvestment Act and the encouragement of lending for these loans to Freddie and Fannie. There's plenty of that analysis out there, and I have little to add that I didn't say yesterday. But I note two paragraphs in which Fed president Yellen describes how to promote homeownership for low-income families.

As a first step, there is a need to develop new strategies that help low-income borrowers�particularly those that may not have extensive financial knowledge�make better and more informed credit choices. Additional investments in financial education and homeownership counseling must be a key component of this strategy. Financial education has been shown to help households manage their finances more prudently, especially in decisions concerning credit, saving, and investment, and it has been shown to reduce the likelihood of default. Calling for more financial education is not a new idea, but challenges remain in funding educational programs and developing appropriate curricula and delivery channels for diverse audiences. Later this morning, you will have a chance to see one new fun approach to teaching children about financial management skills.

Now think about this a minute -- she is calling for more education of adults so that they know how to "make better and more informed credit choices", and her example ends with a "new fun approach to teaching children" financial literacy proposal. Do parents learn from their children? Sure, but what do they learn? I have read many proposals for teaching financial and economic literacy, and they are almost always of that nature -- teach the kids, and they'll teach the parents. The teachers (public school ones, mainly -- you see very few such programs in private schools) of course support that notion, since it provides them new programs, new mandates and new resources. Are we convinced that talking to Johnny about the Stock Market Game helps his parents understand the traps in an option ARM mortgage?

Yet this is what they seem to believe. Stan Liebowitz noted a few months ago that the Boston Fed had promoted rules for mortgage lenders that substituted education for objective lending criteria:

[T]he Boston Fed, clearly speaking for the entire Fed, produced a manual for mortgage lenders stating that: "discrimination may be observed when a lender's underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants."

Some of these "outdated" criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification. Instead, the Boston Fed ruled that participation in a credit-counseling program should be taken as evidence of an applicant's ability to manage debt.

Emphasis in original. See this manual for one. Returning to Yellen:

Second, we need to expand access to affordable homeownership opportunities. The gap in homeownership affordability�especially in states like California�is as high as it has ever been. As long as an adjustable rate, interest-only or high LTV subprime loan is the only way to afford a house, low-income families will continue to take on loans that they cannot sustain over the long term, and may be at greater risk of falling prey to unscrupulous lending practices. In stark contrast to the results we are seeing in the subprime market, the vast majority of new homeowners who have gone through affordable homeownership programs�which often involve pre- and post-purchase counseling and support as well as a savings component such as an Individual Development Account�have not defaulted on their loans.

Read that which I emphasized again: As long as homes are so high priced that lower income families cannot get in without a special mortgage vehicle, they will try to use that vehicle. So they must be foolish? Did we do the job the previous paragraph says we should do? If not, why would you recommend education again?

The last sentence refers to Individual Development Account, which is just a savings program where the participant's savings is matched at a 1:1 to 3:1 ratio, with withdrawal limited to the sole purpose of buying an asset like a home, a small business, or higher education. Well yes, of course that would help, but people willing to participate in an IDA self-select for the very attributes that make their chances for successful homeownership more likely: sound budgeting and a willingness to delay consumption. (There's an argument here one could have over personal discount rates, but we could get lost in the weeds there.)

The rest of it boils down to this: as long as we try to push homeownership for the poor -- which confuses the correlation of homeownership and financial stability with a causal link from homeownership to financial stability -- we will face the problem that the poor will take advantage of riskier mortgage vehicles. We will encourage them to have higher leverage in their houses. (Yes, sir, nobody put a gun to their heads. We just put dreams in them, encouraged with itemized tax deductions. Yes, it's still their fault in the end. Yes, but what would you like to do now?) And that will feed back into the banks and mortgage firms and insurance companies and the GSEs, etc.

Can economic education or financial literacy have stopped this? Maybe, but if so we need some different programs.

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